Guide to Analysing Companies

THE CHANGING FACE OF MARKETS
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house) exchange financial assets and the interest payments
due on them, the idea being, of course, that both parties should
benefit from the transaction. In the case of an interest-rate
swap, a borrower who has raised, say, Swiss francs will ex-
change the interest payments on the loan with those of another
borrower who may have raised, for example, dollars.
Another influence on otc trading was the introduction of
the euro, the new currency that came into circulation in 12 Eu-
ropean countries at the beginning of 2002, replacing old stal-
warts such as the Deutschemark, French franc, Italian lira and
Spanish peseta. Financial institutions began trading in notional
euros in 1999, and euro-denominated swaps quickly became a
new benchmark for buyers and sellers of fixed-income instru-
ments throughout Europe as the market for corporate debt in
euros developed.
With much of their currency and interest-rate risk eliminated
by the introduction of the euro, financial institutions needed a
tool with which to reduce the remaining credit risk (the chance
that borrowers might renege on their debts). Credit derivatives –
a way of laying off risk to other investors until the loan matures
– became just such an instrument. Turnover in credit derivatives
remains small compared with that of interest-rate contracts, but
it is growing fast. The British Bankers’ Association reckons that
in early 2002 London accounted for around half the expanding
activity in credit derivatives, and that the market had increased
no less than eight times since 1997.
At the heart of any market is the free flow of information,
which is why, according to Alan Greenspan, veteran chairman
of the Federal Reserve, credit derivatives have proved so suc-
cessful. They not only allow bank treasurers to lay off part of
their risk, by reflecting the probability of default in the price;
they also make the jobs of banks’ loan officers a lot easier. In the
past, banks relied largely on their own credit analysis (together
with what market information they could glean) to tell them
whether a borrower was likely to default. Since the advent of
credit derivatives, they have been able to judge from the price
of a derivative the probability of a net loss in the underlying
loan.
But what about the dangers to those, such as insurance com-
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